Derivatives Implementation Group

Statement 133 Implementation Issue No. G12

QUESTION

Paragraph 68 of Statement 133 (as amended) allows the application of the shortcut method (as discussed in paragraphs 114 and 132) to a hedging relationship of interest rate risk involving a recognized interest-bearing asset or liability and an interest rate swap that meets the criteria in paragraph 68. Can an entity apply the shortcut method to a cash flow hedge of the variability in lease payments for an interest-rate-indexed operating lease?

BACKGROUND

An entity leases property under a lease agreement that provides for rental payments indexed to changes in interest rates and accounted for as an operating lease. The payments on the lease agreement are reset quarterly based on changes in three-month LIBOR. To hedge the variability in expected future cash flows attributable to interest rate risk, the entity enters into a pay-fixed, receive-variable interest rate swap based on three-month LIBOR and designates the swap as the hedging instrument in a cash flow hedge of the variability in the lease payments. Assume that the term, notional amounts, repricing dates, and maturity on the operating lease and the interest rate swap match, and the fair value of the interest rate swap at the inception of the hedge is zero.

The conditions that are required to be met to apply the shortcut method are listed in paragraph 68 (as amended), which states, in part:

   An assumption of no ineffectiveness is especially important in a hedging relationship involving an interest-bearing financial instrument and an interest rate swap because it significantly simplifies the computations necessary to make the accounting entries. An entity may assume no ineffectiveness in a hedging relationship of interest rate risk involving a recognized interest-bearing asset or liability and an interest rate swap if all of the applicable conditions in the following list are met... [Emphasis added.]

RESPONSE

No, the shortcut method may not be applied to a cash flow hedge of the variability in lease payments for an interest-rate-indexed operating lease because, under current generally accepted accounting principles, that lease is not a recognized interest-bearing asset or liability. Although a capital lease is reported as a leased asset and an interest-bearing obligation under FASB Statement No. 13, Accounting for Leases, (and thus the shortcut method could potentially be applied to a fair value hedge of a capital lease's exposure to interest rate risk), an operating lease is accounted for as an executory contract that is not recognized as an interest-bearing asset or liability. The shortcut method may not be applied to a hedging relationship that does not involve a recognized interest-bearing asset or liability. In the above example, the contract is a lease agreement with an escalation clause whose rental payments are dependent on LIBOR-based interest rate levels; the contract is not a recognized interest-bearing financial instrument for accounting purposes. Thus, the shortcut method cannot be applied to the operating lease in the example. The guidance in Statement 133 Implementation Issue No. G7, "Measuring the Ineffectiveness of a Cash Flow Hedge under Paragraph 30(b) When the Shortcut Method Is Not Applied," would then be relevant.

The above response has been authored by the FASB staff and represents the staff's views, although the Board has discussed the above response at a public meeting and chosen not to object to dissemination of that response. Official positions of the FASB are determined only after extensive due process and deliberation.